It is no secret that I would prefer that the ECB would introduce an NGDP level target. However, that is obviously utopian – I might be a dreamer, but I am not naïve. Furthermore, I think less could do it. In fact I believe that the ECB could end the euro crisis by just simply returning to the old second pillar of monetary policy in the euro zone – the M3 reference rate – and sticking to that rather than the highly damaging focus on headline inflation (HICP inflation).
The equation of exchange – MV=PY – was the starting point of the ECB’s monetary pillar. Lets rewrite the equation of exchange in growth rates:
(1) m + v = p + y
m is the yearly growth rate in M3, V is the yearly growth rate in M3-velocity. p is yearly inflation (growth in the GDP deflator) and y is real GDP growth.
We can rearrange (1) to:
(1)’ m = p + y – v
The ECB used to calculate the M3 reference rate from a modification of (1)':
(2) m-target = p-target + y* – v*
Where m-target is (was!) the ECB’s target of M3 growth (the reference rate), p-target is the ECB’s inflation target (2% – note the ECB did not pay attention to the difference between the GDP deflator and consumer prices), y* is trend-growth in real GDP and v* is the secular trend in velocity.
I have looked at the data from 2000 and onwards. M3-velocity on averaged dropped by 2.5% per year from 2000 and until 2007. I on purpose exclude the crisis-years as velocity has contracted sharply since the autumn of 2008. Normally trend real GDP growth is assumed to be 2%. That gives use the following M3-target:
(2)’ m-target = 2% + 2% – (-2.5%) = 6.5%
This is higher than the reference rate historically used by the ECB, which used to “target” 4.5% M3 growth. The difference reflect a difference in the assumption about trend-velocity growth.
I have plotted the actual level of M3 and a target path for M3 based on 6.5% M3 growth. I have assumed that monetary policy was “right” in the start of 2000. This is completely arbitrary, but nonetheless the result of this little exercise is striking. See the graph below:
We see clearly that M3 grew nicely along a 6.5% growth path from 2000 and until 2006. In this period inflation also behalf nicely and fluctuated around 2% and nominal GDP also grew at stable pace. However, from early 2006 actual M3 growth clearly was outpacing the 6.5% growth path. In fact the gap between the actual level of M3 and the 6.5% growth path reached nearly 10% in 2008 indicating an extremely easy monetary stance.
The increased gap between actual and “targeted” M3 (as defined here) from 2006 to 2008 not surprisingly increased imbalances in the European economy – acceleration in asset price growth, sharply larger current account deficits in countries like Spain and Ireland and increasing wage and inflation pressures. In the same period nominal GDP also increased well above the pre-2006 trend in some euro zone crisis This surely was the boom years. Had the ECB taken its M3 reference rate (at 4.5%!) serious then it would have tighten monetary policy much more aggressively in 2006-7 – instead the ECB spend a lot of time making up excuses in that period why the high growth in M3 should be disregarded.
However, when crisis hit in 2008 M3 growth started to slow sharply and the gap between actual M3 and the 6.5% growth path narrowed fast and was fully closed in Q2 of 2010. The timing of the closing of the “money gap” (the difference between actual M3 and the target M3) is extremely interesting. Even though Europe was hard hit by 2008-9 there was not much talk of an “euro crisis”. In 2008 the focus was on the “subprime crisis” and in early 2009 the focus changed to the crisis in Central and Eastern Europe – however, nobody was talking about euro crisis before 2010 and since then the focus has nearly solely been on the euro crisis. Just take a look at Google searches for “subprime crisis” and “euro crisis”. One can argue – and Austrians would undoubtedly do so and I have some sympathy for that – that the slowdown in M3 growth and the closing of the money gap during 2009 was a necessary correction to a monetary induced boom. This (as do my graph above) of course completely disregard the collapse in M3-velocity. However, even ignoring the collapse in velocity it is clear that at least from early 2010 European monetary condition – measured by the money gap – became excessively tight. In fact monetary policy became deflationary and it can hardly be a surprise that the ECB now for years have undershot a 2% growth path for prices measured by the GDP deflator (as I have documented in an earlier post).
The simple calculation should convince any old-school monetarist (and I hope most others) that monetary conditions are excessive tight in the euro zone and has been so at least for 2 years. One can especially wonder why the Bundesbank so stubbornly resist further monetary easing when M3 so clearly shows the deflationary pressures in the euro zone. After all it was the Bundesbank that originally got the ECB to target M3.
Target 10% M3 growth until the end of 2014
As I said above I have no illusions that the ECB will start targeting the NGDP level or even the price level. However, I could hope that at least the ECB would start taking its monetary pillar serious and once again introduce a proper target for M3. Furthermore, the ECB should acknowledge that M3 growth has strongly undershot what would have been a proper target of M3 in recent years and that monetary policy therefore needs to be eased to make up for this policy mistake.
As the money gap is negative at the moment the “new” M3 target needs to be higher than 6.5% growth. In fact I believe that the ECB should announce that it will target 10% M3 growth until the end of 2014 or until the money gap has been closed. If indeed the ECB where to ensure 10% y/y growth in M3 from now and until the end of 2014 then that would be sufficient to close the money gap (See the green line in the graph above). And my guess is that most likely that would end the euro crisis. How hard can it be? (and yes, the ECB can easily increase M3 growth and it could start by announcing the new M3 target).
PS back in 2006-7 I was not screaming for monetary easing in Europe. In fact in my day-job I was screaming about the need for monetary tightening and the risk of boom-bust in countries like Iceland and the Baltic States and South East Europe.